Looking at whether a share price rises or falls during stock market trading is only half the picture. How much the company pays in dividends can be equally as important.
Anyone who has had the good fortune to have had a large amount of money to invest over recent years will know what a challenge it is to find a decent, steady return on their money.
Investing in stocks that pay attractive dividends, or equity income investing as it is known, can be a good way to generate relatively solid, attractive levels of income over time.
Higher levels of income
While investing in stocks is far from being without risk, the average dividend yield on a FSTE 100 company is 3.86%, seemingly far more attractive than the interest rate offered by a high street bank account.
Some companies tend to pay much more in dividends than others, so if you target the higher dividend paying stocks it should be possible to generate even higher levels of income.
For instance, FTSE 100 oil majors BP and Shell currently have dividend yields of over 6%.
Reinvesting the dividends you receive from your equity portfolio can lead to much higher returns over time than you would get from just the capital appreciation of the underlying shares alone.
That is, if you use the dividends you receive to buy more shares in high-yielding stocks that continue to rise in price over time.
Neil Woodford is one of the most celebrated fund managers of all time and a pioneer of equity income investing. When he was at investment firm Invesco Perpetual, £1,000 invested in his equity income fund would have grown to £23,000 over a period of 25 years.
As a general rule of thumb, the more frequently you receive and reinvest your dividends, the higher your long-term returns are likely to be.
Those of us who are looking for periodic income from our investments may prefer to sacrifice this potential longer-term gain to instead receive the dividend payments in cash as they arise.
Distributing the profits
So, what are dividends anyway? An important thing to remember about dividends is that they are normally expected to be paid out of a firm´s profits.
Dividends are, therefore, by their very nature far from guaranteed, and can fluctuate from year to year.
Being paid directly out of a firm´s profits, dividends are a means of distributing earnings generated by the business to shareholders.
A typical dividend-paying FTSE 100 firm will make two dividend payments during a financial year. Added together these two payments form the annual dividend paid by the firm, which is then used to calculate the firm´s dividend yield.
The dividend yield on a given stock is simply the annual dividends received by shareholders, divided by the company´s market capitalisation on the stock market.
It tells us the percentage yield over a year that we will receive on the shares if we buy into the shares at that point in time, and providing the company chooses to maintain its current dividend policy.
However, even if the dividend payments themselves stay the same, the dividend yield on a stock will fluctuate as the share prices moves in the market.
For this reason, a big share price fall can boost a stock´s dividend yield.
Companies tend to disclose the amounts they will pay to shareholders for the year when they publish their financial results.
By visiting the investor section of a company´s website, you should be able to find the firm´s financial calendar with the actual dates on which it plans to make dividend payments.
On the calendar, you should see a “record date”, which is the date you must be on the company´s record as a shareholder in order to receive the dividend payment.
When the shares are said to trade “ex-dividend”, it´s too late for someone to purchase the shares in the market and be eligible to receive the dividend. Put another way, once ex-dividend, the dividend payment belongs to the seller of the shares rather than the buyer.
Once a stock has been declared as ex-dividend, the shares will normally drop in value by the amount of the dividend. Therefore, prior to the ex-dividend date, the value of the dividend tends to be factored into the share price.